Does a Car Loan Hurt Credit Score? Exploring The Impact

Are you considering financing your next car purchase but worried about its potential effects on your credit score? Many Canadians share your concern, as understanding how car loans affect credit scores can be confusing.

In this article, we'll cover the impact of taking out a car loan on your credit score, addressing common misconceptions, and providing you with a clear picture of what to expect.

How Does a Car Loan Impact Your Credit Score?

It's crucial to start by understanding the fundamental mechanics of credit scores. Your credit score is a numerical representation of your creditworthiness, based on your credit history.

Lenders use it to assess the risk of lending you money. When you apply for a car loan, your lender will make an inquiry into your credit history. These inquiries are categorized into two types: soft and hard inquiries.

A soft inquiry, also known as a soft pull, occurs when a person or organization checks your credit report for informational purposes, such as when you check your own credit report or when a potential employer does so as part of the hiring process. Soft inquiries do not affect your credit score.

On the other hand, a hard inquiry, also known as a hard pull, happens when a lender or creditor assesses your credit report as part of a lending decision.

This type of inquiry may slightly impact your credit score, but it's important to note that the impact is usually minimal.

When you apply for a car loan, the lender will perform a hard inquiry to evaluate your creditworthiness. This inquiry may cause a temporary dip in your credit score, typically by a few points.

However, this small reduction is usually short-lived and should not be a cause for significant concern.

The Complex Nature of Credit Scores

Understanding credit scores and their impact is not always straightforward. Your credit score depends on various factors, and the impact of a car loan is intertwined with your overall credit history.

If you make consistent, on-time payments and manage your credit responsibly, a car loan can actually have a positive influence on your credit score over time.

On the other hand, if you fail to make your car loan payments on time or miss them altogether, it can significantly damage your credit score.

Delinquent payments will be reported to credit bureaus, and your credit score will take a hit.

The Role of Payment History

One of the key factors in determining your credit score is your payment history, which accounts for about 35% of your FICO credit score. Timely payments on your car loan can boost this aspect of your credit history.

It's important to make all payments on schedule to demonstrate responsible credit use, which can help improve your credit score over time.

Loan Amount and Credit Utilization

The amount of your car loan also affects your credit score, as it contributes to your credit utilization. Credit utilization is the ratio of your credit card balances to your credit limits.

Ideally, you should aim to keep your credit utilization below 30%, as exceeding this threshold can negatively impact your credit score.

A substantial car loan can increase your credit utilization, potentially affecting your score temporarily.

Diversity of Credit Types

Another factor that influences your credit score is the diversity of your credit accounts. Lenders prefer to see a mix of different types of credit, such as credit cards, installment loans, and mortgages.

Taking out a car loan adds to this mix, potentially benefiting your credit profile by showing that you can manage various types of credit responsibly.

More Good Than Bad

The impact of a car loan on your credit score is not all negative, as some may fear. It primarily depends on how you manage your loan and your overall credit history.

While the initial hard inquiry may cause a slight dip in your score, making timely payments and being responsible with your credit can lead to a positive influence on your credit score over time.